In order to create a real estate pro forma for an income producing property you will need to make assumptions. These assumptions will be used to project your property’s cash flows into the future. You may also need to use assumptions to generate your property’s current operating budget as you may not have the ability to get exact budget numbers if the property is not on the market. Without knowing the current operating budget, you will need to use assumptions to calculate your property’s cash flows today, and then use more assumptions to project your property’s cash flows in the future.
In order to start your pro forma, you will need to input or calculate your building’s Net Operating Income (NOI), which is determined by your building’s operating income minus operating expenses. If you don’t have exact figures on your property’s operating income and expenses, and that is true for the majority of real-estate deals, you simply must estimate them using assumptions determined by market information and standards. Solid, realistic assumptions will be the cornerstone of a good real estate pro forma. The most common assumptions you will need to generate NOI are rental rates, expenses rates and vacancy rates.
For rental rates and vacancy rates, you should employ the average rental rate for similar buildings inside your market area, usually quoted as dollars per net square foot for rental rates and also a percentage for vacancy rates. For expense rates, you should estimate the entire annual operating expense, usually in dollars per net square foot. These are expenses important to operate the property, for instance; electric, water, landscaping, maintenance, etc., in addition to taxes and insurance. Each industry sector and lease deal can have different assumptions. For instance, retail and industrial leases are usually triple net (NNN), meaning the tenant pays all operating expenses; therefore, this assumption would be negligible for the landlord. In case your property is an apartment or office building, you must assume you will have to pay some in the operating expenses.
Once you have generated your property’s current NOI, you may then use assumptions to project cash flows in the future. This is commonly done by using inflation. Inflation is the assumed rate by which earnings will grow over a period of time. It is usual in a real-estate deal to assume inflation of NOI is going to be generally near to the CPI (Consumer Price Index), or general inflation or your existing market. If your inflation assumption is just too high, the compound effect will greatly exaggerate your future cash flows and provide an incorrect valuation of your respective property’s future value. It is vital to not over-estimate your inflation assumption.
When your assumptions are input and your pro forma is built, it is very important to run sensitivity analysis on your entire pro forma and assumptions. Sensitivity analysis is performed by changing each assumption and finding out how those changes in each assumption affect your pro forma outputs, such as IRR and NPV. Sensitivity analysis can help to target the assumptions which are critical to your pro forma.
For more info and tricks on creating real estate pro forma models and templates, please see the Pro Forma GURU: Guide for Real Estate Investing at www.ProFormaGURU
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